Greetings:

Volkswagen's ongoing scandal over phony diesel emissions isn't just a big story in the auto industry. It also raises key questions for diesel as a transportation fuel at a time when automakers are striving to meet ever-tougher government fuel economy rules.

Just how serious is the revelation that VW, the largest automaker in the world, used special software in some of its diesel-powered cars to cheat on emissions tests? First, consider the numbers. The company estimates that about half a million of the cars it sold in the U.S. with four-cylinder diesel engines during the past five years were programmed to emit fewer pollutants when undergoing emissions test. Worldwide, the total might be as high as 11 million vehicles sporting the "defeat device" software.

The resulting fines from regulators in the U.S. and other countries could run into the billions of dollars. (No wonder VW's stock has plummeted by 36% since news of the emissions cheating broke.) Even more crucially, the company may have seriously undermined its reputation with customers, many of whom are undoubtedly feeling less inclined to trust a brand that actively sought to evade the rules. The fact that VW markets these polluting engines as "clean diesels" that get great fuel economy adds insult to injury.

"It really is a giant deal" for Volkswagen's brand perception, says Kelley Blue Book Executive Market Analyst Jack Nerad, though he warns that it's too soon to gauge the financial impact of all the fines and lost sales the company will suffer. The brand's loyalists, who are devoted to VW in general and its diesel-powered cars in particular, will be especially put off, he reckons.

"I would say it's egregious," adds longtime auto industry analyst and independent consultant Bill Visnic. Rigging cars with software to cheat on emissions tests points to an "institutionalized" problem at VW. This wasn't the act of some rogue engineer or an oversight borne of cost cutting, but rather a "concerted effort to skirt regulations."

VW is under pressure to fix the problem in millions of faulty cars. But any solution is going to be painful. Because diesel engines tend to emit more oxides of nitrogen (or NOx) than gas-powered units, carmakers normally add special exhaust treatment gear to their diesel models to meet clean air rules. Typically, that requires a system to inject a chemical called urea into the exhaust, thus neutralizing the harmful NOx emissions. Nerad thinks VW will have to retrofit its affected cars with such a system, which could cost thousands of dollars per vehicle. Visnic thinks VW will opt for a software fix that will reprogram the cars to emit less NOx. The company might also have to install a new catalytic converter. Or it might do some combination of the three.

Any physical retrofit will be expensive and tough to carry out. A software fix might be cheap, but it will probably cost horsepower and fuel economy, making the car less enjoyable and economical to drive. In other words: Spend a fortune on a complicated recall or degrade the driving experience for your customers. Aren't you glad you aren't in VW management right now?

The Fallout for Diesel

Are VW's woes the death knell for diesel-powered cars, though? Long a niche market in the U.S., diesel has been enjoying a modest resurgence in recent years. Modern diesels are very different from the wheezy, smoke-spewing versions many drivers might remember from a few decades ago. And because diesels tend to be more fuel efficient than their gas-powered cousins, some automakers have been hoping they can reach their government-mandated fuel economy goals in part by selling more diesels. In the past few years, there's been an increase in the availability of diesel models, not just from VW, but also from Mercedes-Benz, BMW, Ram, Jeep and other brands.

Despite the stigma, odds are customers who wanted a diesel before will still want one, says Visnic. Those drivers tend to be familiar with the technology and the unique advantages of diesel engines (lots of torque and towing capability, along with high fuel mileage). And those folks will probably understand that what VW did doesn't indict diesel power entirely.

Savvy buyers might use the current situation to their advantage. VW can't sell new four-cylinder diesel models until they get the emissions up to snuff, but that shouldn't take too long. When those cars return to dealers' lots in a few months, they'll likely require some pretty enticing discounts to win back apprehensive or angry customers. Normally, VW's "clean diesel" models sell at a premium to comparable gas-powered versions, but odds are good shoppers who aren't put off by the recent deception will see some sweet bargains. Moreover, they'll have plenty of leverage to negotiate a better price, since Volkswagen's U.S. sales depend pretty heavily on a high diesel take rate. When it comes to clean diesel, it's going to be a buyer's market.

A "Black Eye"

Lost in all the talk about VW's perfidy in cheating the emissions tests is the fact that they were able to get away with it for such a long time. Only when a private research consortium started studying the company's diesel emissions did word start leaking out that something was amiss. Otherwise, it's impossible to say when, or if, the U.S. Environmental Protection Agency would have caught on.

That failure is a "black eye for the regulators," says Nerad. The fact is, the agency doesn't test every new car to verify the maker's claimed fuel efficiency, and it doesn't have the resources to look too closely at emissions compliance, either.

But look for EPA to compensate by scrutinizing other brands' diesel models much more closely now. Whether the agency uncovers any more funny business is impossible to predict, though it should be noted that other automakers use expensive chemical injection systems to clean up their diesels' exhaust, and it seems unlikely that they'd go to such an expense if they weren't trying to comply with the rules. Still, when regulators suddenly focus their attention on a problem they'd missed for years, you can never be sure what else they'll find.

Sincerely,

Jim Patterson

jpatterson@kiplinger.com

P.S. Don't hesitate to write me, directly with questions or comments about any of the topics we cover, or anything else energy related. You can find previous issues of Kiplinger's Energy Alerts or Kiplinger's Tech Alerts here.